Buying a new home: what should you do with the old one? This approach could save you a hefty, unnecessary tax bill

These are two sides of the same coin: while the booming property market continues to break records for sales volumes and prices, the stock of homes for sale is falling to record lows.

Many owner-occupiers have joined the buying rush, fearing that any delay could cost them their last chance to upgrade within their budget. Some have chosen to sell homes that no longer meet their own or their family’s needs to help fund the deposit on a new home. Others, realising they may never have the opportunity to buy back a home sold now, have chosen to keep their existing property as a rental.

What do those in the latter group need to do, and how should they go about it? Accountant Anthony Appleton-Tattersall, who specialises in property matters, offers a practical guide. 

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Keeping your former home as a rental after buying a new one may be your first step into property investment. If all goes well, you may look forward to earlier financial freedom and a comfortable retirement. Financially, however, this is not always feasible. Even if funding is no problem, getting the timing right is crucial. And even with ample funds and perfect timing, your home may not necessarily be a suitable rental property for the market.

So, if the finances and timing are right, first make sure you carefully consider how suitable your home actually is.

Does it have the qualities of a good rental property?

Here are some factors to weigh carefully before deciding to rent out your home:

• Spend some time researching rental listings on Trade Me and contacting local property managers to establish whether there is strong rental demand in your area.
• What return could you expect? Try this formula: gross yield = weekly rent × 50 / property value. Compare that yield with other potential investments and the cost of debt.
• Consider whether subdividing the property or adding another bedroom could improve the return.
• Would the rental property’s maintenance costs be low and reasonable? People generally buy homes because they like them, rather than making a choice based solely on finances. But a rental property requires a different perspective.

Finally, do not overlook your own and your family’s emotional attachment to the home. When it comes to deciding whether to turn it into a rental, you may find that attachment presents a substantial obstacle. After all, while good tenants may care for and use the home as thoughtfully as you do, perfect tenants can be hard to find. 

Restructure assets to avoid a hefty tax burden

The vast majority of New Zealand landlords are mum-and-dad investors relying on rent to support their retirement. Figures previously obtained under the Official Information Act showed that almost 80% of New Zealand landlords owned just one rental property. Often, that property was their former home. In many cases, no asset restructuring had taken place, leaving owners with a substantial, unnecessary tax burden. How can this unnecessary expense be reduced?

Most accountants generally advise paying off the mortgage. Overall, that is very good advice. Having lived in the home for many years, you have probably paid off the entire mortgage, or at least a substantial portion of it. That is an excellent position to be in.

But if a mortgage remains outstanding and you now want to use the home as a rental, the outlook may be less favourable. Consider this example:

A family bought a home in 2012 for NZ$400,000, with a mortgage of NZ$320,000. Over the years, they worked hard to repay the loan and took advantage of various interest rate reductions. By early 2021, their mortgage debt was down to just NZ$100,000. Better still, the home’s value had risen to NZ$900,000. 

They now buy a new home for NZ$1,200,000. However, because they have put all their money into repaying the mortgage on the old property over the preceding years, their borrowing for the new home is approved using the equity in their old home. Their total debt is now NZ$1,300,000.

Without any restructuring of property ownership, the new NZ$1,200,000 debt is entirely personal, because its purpose is to buy their own home. Which property is used as security does not matter: the debt is non-deductible. Only the NZ$100,000 remaining from the original purchase of the old home qualifies for tax deductions, meaning its interest costs can be deducted from rental income before tax is calculated.

At this point, consider transferring ownership of the old home to another entity, usually a look-through company (LTC), although a trust is also an option. This allows the debt to be restructured. The new entity buys the home at its market value of NZ$900,000 and can raise up to NZ$900,000 in deductible debt against it. Total debt remains NZ$1,300,000, but only NZ$400,000 is non-deductible personal debt. At the current prevailing interest rate of 2.5%, this could provide annual tax savings of up to NZ$6500. If interest rates rise, the benefit will multiply. 

However, several points need attention before restructuring assets:

(1) The restructuring described above is subject to the bright-line test. This means that if the property is sold again within the bright-line period, currently five years, any subsequent capital gain must be taxed.

(2) Also, if you sell the home within a few years of first buying it, seek specific tax advice to ensure you have not previously breached the bright-line rules, which assess capital gains tax on residential investment property. Private homes can be exempt from the bright-line rules, but exceptions apply.